MIND C.T.I. Ltd. (MNDO) is an Israel-based supplier of CRM solutions for providers of telecommunications services (e.g., wireline, wireless, Internet, cable TV). This is a micro-cap trading for a market capitalization of just $31.5 million versus cash and investments of $17.5 million and no debt. The company has been consistently profitable (adjusting for some non-cash impairments).

The company’s CEO owns around one-fifth of the company and has, with the board’s approval, created a dividend policy that is as shareholder friendly as any I have seen. On an annual basis, the company distributes 100% of its previous year’s EBITDA + Financial Income (expenses) – Taxes. This isn’t a new policy either (though the exact basis of what is paid out changed slightly); the company has paid out eight massive dividends equal in the aggregate to $42.2 million since 2003 (or 133% of its current market cap).

This is the only time I have found a company that has a policy like this outside of the income trust industry, and I am extremely impressed. I believe these actions go a long way toward showing that the company is managed in the interests of shareholders.

Let’s take a look at the company’s historical returns (adjusted for the non-cash impairments):

MIND C.T.I. Ltd. - Historical Returns, 2004 - 2Q 2011

Here we see that the company has historically earned relatively lackluster returns. Worse still is the fact that the company’s equity, assets and capital employed have declined during this period (the result of share repurchases, impairments and the company’s generous dividend policy). Let’s see if the company’s revenues and margins can help identify the problem areas.

MIND C.T.I. Ltd. - Revenues and Margins, 2003 - 2Q 2011

Here we see that the problem has largely been the result of a volatile operating expenses. It is somewhat to be expected for a micro-cap to have more volatile margins, as small changes in expenses from year to year can cause dramatic swings. In valuing companies with unstable margins, it is important to look at normalized margins rather than focusing on a single year. I’ve kept this in mind when completing my valuation, as discussed below.

Let’s take a look at free cash flows.

MIND C.T.I. Ltd. - Cash Flows, 2003 - 2Q 2011

Here we see that the company generates an amazing amount of free cash flow relative to its size. Over the period presented, the company’s free cash flow has averaged $4.06 million per year, which translates to an ex-cash yield of 29% at today’s market cap!

In valuing MNDO, I assumed zero or negative growth in the top line (I would rather be pleasantly surprised by growth than utterly dependent on it), and that margins would revert to slightly below the company’s long run adjusted averages. I derived free cash flows which in all cases were equal to or less than the company’s historical average free cash flows. The result shows a company that is between 25% and 40% undervalued, showing that the company was fully value as recently as a few months ago. Using more liberal assumptions easily shows a company priced half-off.

One strange thing about the company is that it recently issued warrants to a customer in exchange for a sales contract. These warrants are now far out of the money (interestingly, around the high end of my valuation range) and expire next year. The company pointed to its “special relationship” with the customer and interest in a long-term partnership. I am not a fan of this and I think the company’s explanation for the warrants is weak, but given the CEO’s ownership and past actions, I believe shareholder interests are well represented.

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